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Monday, July 25, 2011

The Default Price of Oil

Even the threat of default is causing jitters in financial markets, especially those that pay close attention to US debt instruments. There is a real prospect of interest rates rising, perhaps sharply. This would have three effects that push oil prices higher:

Higher interest rates exacerbate the inflation rate. With higher inflation, many investors retreat to commodities as a hedge. A boom in commodities has been underway for a few years and would likely accelerate were interest rates to go up.

Default, or a threat of default would add further downward pressure on the dollar, which has enjoyed a special status in the world as the safest investment because of US economic and political stability. As the chart shows, the price of the dollar is inversely correlated with the price of oil: as the dollar weakens, the price of oil goes up. Oil has nearly tripled in the past two years as the dollar sagged.

Both the volatility and the continuing weakness of the US dollar have added to calls to replace the world bench-marking of oil, now in dollars, with a basket of currencies. If oil were no longer dollar-denominated, the demand for dollars would be decoupled from the demand for oil, which would then rise without the anchoring effect the dollar provides.

While each of us as individuals can make some choices to lessen our personal dependence on oil, and so lessen the blow somewhat, as a nation we are much more vulnerable:

No one knows precisely at what point oil begins to substantially hinder consumer spending and slow commercial activity - but this much is known: every $1 per barrel rise in oil decreases U.S. GDP by about $100 billion per year and every 1 cent increase in gasoline decreases U.S. consumer disposable income by about $600 million per year.

With more GDP declines we have the twin effects of lower tax revenues and higher demands for government services, which lead to larger debts and long-term deficits. Wash. Rinse. Repeat.